Crumpling Up the Dollar

Updated from 3:32 p.m. EDT

Stocks fell in concert with the dollar Monday after Treasury Secretary John Snow effectively abandoned the so-called strong dollar policy or, at least, gave tacit approval to the greenback's recent weakness. On Saturday at a meeting of finance ministers from the Group of Eight major industrialized nations, Snow said the dollar's fall in the past 15 months has been "a fairly modest realignment," and that the strong dollar policy refers to it being "hard to counterfeit," among other things unrelated to its market value.

Amid the stock market's rally since mid-March, many bulls cited the salutary effects of a weaker dollar as an underpinning for the advance, notably improving earnings of multinational corporations. All that changed Monday, although complacency about the significance of a weaker currency remains intact.

In part because of the dollar's weakness, the Dow Jones Industrial Average fell 2.1% to 8493.39, the S&P 500 shed 2.5% to 920.77 and the Nasdaq Composite lost 3% to 1492.80.

The good news is there was no panic evident Monday in either stock or currency trading, although the dollar ended sharply lower vs. the euro (see below). Equity trading volume was down from recent levels, suggesting no rush for the exits, although pretty solid for a Monday at 1.35 billion shares on the Big Board and nearly 1.7 billion in Nasdaq trading.

The bad news is there wasn't more evidence of concern among traders and market watchers about the significance of the dollar's weakness, much less the recent spate of terrorist bombings in the Middle East. Although the CBOE Market Volatility Index rose 9.7% to 23.04, its Nasdaq counterpart rose a scant 0.3% to 31.10, suggesting traders' continued faith in the recent tech-led advance. Most observers seem to think this setback in shares is a natural retracement of gains registered since the mid-March lows and nothing to get too upset about.

Meanwhile, strategists such as Thomas McManus, an equity portfolio strategist at Banc of America Securities, continue to urge traders to "buy the dips," in part because "we still anticipate upside surprises because of a weaker dollar, lower energy prices and fiscal stimulus." Pundits from's Jim Cramer to The New York Times' William Safire echoed this "a weaker dollar is good" viewpoint.

Those folks may be right, but after marching higher in lockstep through the late 1990s, it seems unlikely the dollar and stocks can now proceed in the opposite direction for very long. To reiterate, panicking is bad, but sometimes a little worry is justified.

"By appearing to embrace a weaker dollar, they're removing safety nets," said David Gilmore, economist and partner of Essex, Conn.-based Foreign Exchange Analytics. "Pull those out and you're on the high wire with nothing to catch a collapsing dollar."

As alluded to in a column Monday, Gilmore said that by stating its desire to let the markets set exchange rates for the dollar, Snow may have undermined the administration's capacity to intervene if the dollar's decline becomes overdone (as tends to occur in currency markets).

Snow Job

Snow may have stated the facts of what the strong dollar policy really means. But as discussed here, the strong-dollar rhetoric, which began under Treasury Secretary Robert Rubin in 1995, had meaning to currency traders. They presumed that the mantra implied the threat of intervention. Snow's comments this weekend, the latest in a string seemingly designed to undermine the currency, confirmed that threat is no longer applicable.

"The mere fact the spokesman of the world's most liquid currency described a 21% decline in the Dollar Index since January 2002 as being 'modest' is another sign of approval of the dollar's decline," said Ashraf Laidi, chief currency strategist at MG Financial Group. "It's a tacit backing of the decline. Currency traders are good at reading between the lines, but Snow's statements leave very little room for imagination."

As expected, the dollar fell sharply when Asian markets opened overnight Monday. The declines continued in Europe, with the euro hitting as high as $1.1740, just below the level it was introduced at in January 1999, and the dollar trading as low as 115.12 yen.

The dollar's fall was halted at about 8 a.m. EDT, however, after the Bank of Japan (BOJ) apparently intervened to buy dollars and weaken the yen. In late New York trading, the euro was at $1.1656, well up from Friday's close of $1.1574, and the dollar was at 117.135 yen vs. 115.97 late Friday.

"There's no doubt the Japanese were massive buyers of dollars today," said David Greenwald, partner at Scalene Partners, a currency-focused hedge fund. "The Japanese have their internal policy: They won't let the dollar weaken" vs. the yen.

Some currency traders speculated the BOJ's intervention approached $10 billion, a level unprecedented for a G8 central bank. In addition, the action was done discreetly, without the coordinated support of other central banks and with the BOJ using Japanese banks as intermediaries, rather than doing the dollar purchasing directly.

Race to the Bottom

There's the rub. The Bush administration and the Federal Reserve seem intent on weakening the dollar, and that should help U.S. exporters and fight deflationary pressures by making imports more expensive. However, the Japanese don't want the yen to strengthen too much, because that will hurt pricing of their exports to the U.S. Moreover, because the Chinese yuan is pegged to the dollar, a weaker greenback makes Chinese exports that much more price competitive vs. their Japanese rivals, further hampering Japan's ability to export itself out of economic stagnation.

"The Japanese and U.S. are at odds with one another," Laidi agreed. "It's hard to say to Japan, which has been in deflation for four years, 'strengthen your currency,'" as the latest comments from Snow seem to imply.

Meanwhile, European officials mainly cheered the euro's rise, until very recently. In recent weeks, some European Union ministers have suggested a move much above $1.20 by the single currency would undermine the competitiveness of European manufacturers. For example, Volkswagen AG cited the strengthening euro as a factor in its disappointing quarterly results.

"Asia is a big trouble spot, because everything is dollar linked," said Greenwald, suggesting the yen is also linked to the greenback, albeit not formally, because of the Bank of Japan's policies. As a currency trader, he hopes the Chinese allow the yuan to float but believes it won't happen anytime soon. A weaker yuan "doesn't mean the risk of capital flight" from China right now, he said.

But going forward, "it's a big issue," he continued. "Europeans will say 'we've done our part. U.S. goods are flowing in, so how come you're not selling in Asia?' Meanwhile, those European countries will be flooded with cheap Asian goods."

Such a scenario brings us to "the possibility of competitive currency devaluations aimed at short-circuiting the very process of global rebalancing," as Stephen Roach, chief global economist at Morgan Stanley opined Friday. The economist correctly forecast the Japanese authorities would "draw a line in the sand" when the dollar approached 115 yen -- as occurred Monday -- and suggested a euro move into the $1.25 range would prompt a similar response from European authorities.

"With the European and Japanese economies in bad shape, the risk is that authorities in those countries believe that they, too, are deserving of the weaker currency," Roach continued, suggesting the nation with the largest current account deficit -- in this case the U.S. -- has historically ended up with the weaker currency. "To the extent that Japan and eventually Europe can put a limit on currency realignment, the immediate imperatives of structural reform would then be lessened. And the politicians would then avoid the necessity to embrace reforms, thereby surviving to serve yet another term."

Many would argue the Bush administration is adopting policies aimed at weakening the dollar -- or lessening its robustness -- for those very same political reasons. Roach's point is that a weaker dollar is an unavoidable necessity to bringing about global rebalancing "away from U.S.-led excess demand" -- which has prevailed since the mid-1990s -- "toward more support by domestic demand from Europe, Japan, and even the developing world."

To the extent officials in Europe and Japan resist such a rebalancing -- either because of short-term considerations or (as in Europe) policy mandates that inhibit looser monetary policies -- "the imbalances of a lopsided global economy can only intensify," Roach concluded. "That would make for an even nastier endgame."

In some regards, Snow is right and the dollar's weakness so far has been fairly modest -- the Dollar Index is only down about 8% so far this year. Perhaps more dollar weakness, provided it remains orderly as the recent decline has largely been, including Monday, will spur more positive results for the U.S. economy and equity markets, helping boost economic growth worldwide.

However, if Japanese officials -- and ultimately their European counterparts -- attempt to fight the dollar's decline and a "race to the bottom" among major currencies results, financial assets around the globe are likely to suffer greatly.

Notably, gold futures rose 3.5% to $367.10 Monday while the Philadelphia Stock Exchange Gold and Silver Index rallied 3.1%.

Aaron L. Task writes daily for In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to Aaron L. Task.

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